Business Of Finance: Raw Materials Are The 'Risks'

In financial services, the concept of raw materials takes on an unspoken form—it's not steel nor grain, but rather the intangible yet critical element of ‘risk’ such businesses entail. Unlike traditional industries, where raw materials are physical entities, in finance, it's the management of risks that defines success or failure.

At the heart of any financial institution lies the capital, meticulously organised by its founders or owners. However, in deposit-taking entities, it's the public depositors who entrust their hard-earned funds, thereby becoming the custodians of this capital. The decisions and actions of those at the helm, whether propelled by ingenuity or shortsightedness, can either propel the institution to new heights or plunge it into peril.

The second crucial component in this ecosystem is the management of risks, akin to raw materials in a manufacturing plant. However, unlike tangible resources, the risks in finance are multifaceted and ever-evolving. Thus, the challenge lies in orchestrating these risks in a manner that optimally balances potential returns with prudent safeguards. Risks need to be identified, processed, and measured to be able to be managed. With techniques and tools now at hand to measure and hedge risks, earnings could be optimised.

Risk and greed are true enemies. But greed is for transitory gains, which alerts risk to get concurrently managed. The temptation to prioritise immediate gains over long-term stability plays out loudly, particularly when it's perceived that the risks are borne by others, namely, the depositors. This raises a fundamental question: What should take precedence—the identification and assessment of risks or the pursuit of returns?

It's important to understand that this is not a mere philosophical question, akin to the chicken-and-egg dilemma. The unequivocal answer is that the ability to smell risks and manage them must precede the pursuit of higher returns.

Without a thorough understanding of the risks being undertaken, deploying capital to generate returns is akin to navigating treacherous waters blindfolded. If the capital is someone else’s, then it is unethical or may even be illegal. The root of this so-called ethical dilemma lies at the crux of a misunderstanding of the meaning of ‘modern’ in the business of finance, where the pursuit of short-term gains often clashes with the criticality of long-term stability.

Risk management is often misconstrued as militating against the objective of profitability. The allure of immediate returns can be intoxicating, especially when it appears that the risks involved are shouldered by external stakeholders, such as depositors. This perception creates a dangerous illusion of impunity, where decision-makers feel emboldened to prioritise profit-seeking ventures without adequately weighing the associated risks.

However, this shortsighted approach neglects the fundamental principle that every action in finance carries inherent risks, regardless of who appears to bear the burden. The interconnected nature of financial markets means that a misstep in one corner of the industry can reverberate far beyond, affecting not only depositors but also investors, counterparties, and ultimately the broader economy.

In the current times, risks have changed their colour and characteristics and have become more fickle. But that warrants a much greater ability to smell them—not to pretend one’s ignorance to see their existence.

In the pursuit of sustainable growth, the assessment of risks must take precedence over the allure of immediate returns. While it may seem counterintuitive to forego short-term gains in favour of long-term stability, history has repeatedly demonstrated the folly of prioritising the former at the expense of the latter.

Consider the case of the 2008 financial crisis, where rampant speculation and excessive risk-taking fuelled a bubble that eventually burst with catastrophic consequences. Institutions that prioritised short-term gains over prudent risk management found themselves teetering on the brink of collapse, triggering a domino effect that reverberated across the global economy.

In contrast, those who adhered to rigorous risk assessment practices and maintained a steadfast commitment to long-term stability weathered the storm with far greater resilience. While their returns may have been more modest in the short term, their prudent approach ensured the preservation of capital and safeguarded the interests of all stakeholders involved.

Furthermore, the notion that risks can be transferred or externalised to depositors is a fallacy that undermines the very foundation of trust upon which the financial system relies. Deposit-taking institutions are entrusted with the fiduciary responsibility to safeguard depositor funds and deploy them in a manner that maximises returns while minimising risks.

Prioritising short-term gains at the expense of depositor trust is not only ethically dubious but also ultimately self-defeating. A sustainable financial ecosystem is built on a foundation of transparency, integrity, and accountability, where the assessment of risks serves as the cornerstone of responsible decision-making. Moreover, it's not just a matter of prudence; it's a matter of integrity. Utilising depositor funds to pursue speculative ventures without due diligence not only jeopardises the institution but also breaches the trust bestowed upon it by the public. Isn't this, after all, the foundational principle of banking?

In conclusion, for board members, CEOs, and regulators alike, the message is clear: As they navigate the complex landscape of modern finance, boards must embrace a paradigm shift in their approach to risk management and decision-making. Instead of viewing risk assessment as a mere regulatory compliance exercise or a box to be checked, boards should cultivate a culture of proactive engagement with risk at every level of the organisation.

This entails fostering a deep understanding of the interconnectedness between risk and reward, recognising that sustainable growth requires a balanced approach that prioritises long-term stability over short-term gains.

Boards should champion the adoption of robust risk management frameworks that integrate quantitative analysis with qualitative insights, leveraging technology and data analytics to anticipate emerging risks and adapt swiftly to changing market dynamics. Moreover, they must foster a culture of transparency and accountability, where all stakeholders are empowered to voice concerns and contribute to the ongoing refinement of risk strategies.

Surely it is easy, yet tough. It starts with every individual on every board.

It is better late than never.

Srinath Sridharan is a policy researcher and corporate advisor.

Rabi N. Mishra is Senior BFSI Sector Governance and Surveillance Specialist.

The views expressed here are those of the authors, and do not necessarily represent the views of NDTV Profit or its editorial team.